The Fed’s search for a reason to raise interest rates risks creating a policy error. There is no compelling reason for the Fed to hike, or to forego its battle-tested strategy of trying to manage asymmetric economic risks. Moreover, one consequence of a steady downtrend in the Fed’s neutral policy rate is that monetary tightening will bite far sooner than in previous cycles: a 25bp hike could be equivalent to a ~75bp hike pre-GFC. The market appears right to be sceptical about the Fed’s “targeted” rate hike trajectory. However, a lower neutral policy rate would provide resilience to the US yield curve in the event of a Fed hike since this trend is compressing the “equilibrium” term structure of yields. Indeed, this lower term structure helped limit the scale of the summer sell-off in US interest rates, a move we expect to continue to be retraced. We see value in positioning for lower 10yr US yields in both spot and forward space. One risk for the Fed is that while it agonises over how to appropriately conduct monetary policy in a world of a lowered neutral policy rate, by hiking prematurely it could exacerbate its dilemma by helping to maintain this very downtrend in the neutral rate.
An enduring simplicity to yield curves
Yield curves pivot around neutral rates
Interest rate markets, with their array of inter-related yield curves, boot-strapping methodologies, and requirement for both macro and quantitative analytic techniques, can appear to be a daunting asset class to analyse and trade. Yet there is an enduring simplicity to the gyrations of a yield curve. Simply put, the shape of the curve is sensitive to where the market perceives a central bank’s neutral policy rate to lie. If a policy rate moves above neutral, yield curves tend to invert as expectations grow of a future slowdown in growth and reduction in inflation. As policy rates decline below neutral, curves steepen.
Complexity can be layered on this framework…
Of course, complexity can be layered upon this simple framework. Since an interest rate is the market’s expectation of the cumulative movement of the O/N rate, a longer-term yield can lie below the neutral rate for a prolonged period if there is a belief that monetary policy will need to be exceptionally loose for an extended time. In addition, yield curves can embed differing assumptions regarding term premium or credit risk premium.
…but neutral rates provide a valuable analytical and intuitive anchor
Nonetheless, while there is little limit to the degree of complexity that can be layered on a yield curve, a critical framework for analysis is that longer-term yields and the shape of a curve tend to be highly sensitive to the prevailing level of a central bank’s neutral policy rate. An understanding of this can provide some guidance to US curve trends as the Fed tries to raise interest rates without any compelling reason to do so and as they reject their previous battle-tested strategy of focusing on asymmetric economic and financial market risks.
Reasons for the Fed to delay a hike
The Fed targets (with fingers crossed while touching wood) higher rates
The latest FOMC meeting appeared to set the scene for a December increase in the Fed Funds rate – data flow permitting. Moreover, while the Fed’s DOT plot flattened, it still showed a Fed looking to proceed to a 2.9% medium-term terminal Fed Funds rate. Now of course, the DOT plot represents the Fed’s idealised representation of how it wishes the economy to perform, not how it truly expects it to evolve. As such, the predictive power of the DOT plot has been less reliable than a Magic 8-Ball in outlining the path of interest rates. However, it demonstrates the Fed’s bias.
The US economy does not need higher rates
We will not expand in this note the many and varied reasons why we believe the Fed should refrain from tightening and why the economy actually needs greater stimulus in the form of fiscal expansion and a watering down of the wave of regulations that are tightening financial conditions. In fact, we doubt that data flow will prove suitably accommodating to the Fed’s desire to hike and as such we do not expect a December rate hike. These factors are discussed in detail in the note Avoiding the Big Crunch – policies to prevent a deflationary world, but in short the reasons for the Fed to refrain from hiking include:
- The US is not “an island, entire of itself”. The global economy is characterised by weak global demand, downside risks to price stability and manifold sources of potential non-linear economic risks.
- US wage growth and inflation are expected to surprise on the downside due to a combination of far more slack than is implied by the headline U3 unemployment rate and by a diminished pricing power for labour. (At 1.6%, the core PCE deflator has been below the Fed’s 2% target for over 4 years and at 1.7% the 3M/3M is declining from a March peak of 2.2% that alarmed some analysts and investors, many of whom have been looking for a US inflation break-out since 2009).
- A structural, post-crisis increase in risk aversion in the household sector. (Chart 1.) Even with laggardly wage growth, prevailing levels of net worth would historically lead to higher rates of consumption. Similarly, appetite for fresh debt extension by households remains limited: since mid-2007, 75% of the rise in consumer debt has been driven by increased student debt; debt/ disposable income continues to decline as households deliver, and at 105.3% compared to a Q3 2007 peak of 134.5% and is back at levels seen in 2002.
Chart 1. US households have increased their marginal propensity to save post-GFC
- A worrying combination of highly indebted corporates and a reduced outlook for profitability. At a time when unit labour costs are being driven more by weak productivity that higher wages relative to past cycles, there is the potential for companies to respond to weaker profits by shedding workers rather than by raising product prices or by accepting lower profits as a cost of a tight labour market increasing the labour share of income (The danger of the Fed’s presumed US exceptionalism, real yields, illusory alpha, declining neutral rates and the need for core received positions).
A negative real US Fed Funds rate
An additional concern with a Fed tightening, and the focus of this note, is that monetary conditions may tighten far more quickly than commonly perceived. This is because the neutral level of the Fed Funds has declined so precipitously since the financial crisis. In the decade prior to the GFC the “neutral” Fed Funds rate was around 5.0-5.5%, or 3.0-3.5% in real terms based on the Fed’s 2% target for inflation. However, Fed Governor Yellen has stated that the current level of neutral Fed Funds is negative while other Fed studies have suggested it lies just below 0%. We assume a neutral real Fed Funds rate of -25bp. That implies a nominal neutral Fed Funds rate of just 1.75%.
Reasons behind the declining neutral policy rate
There are many factors that have driven the neutral policy rate lower. Key explanations include:
- The trend rate of growth has slowed in many key economies since the GFC, due to a combination of demographic trends and a decline in productivity growth.
- The wave of regulations that have been applied to the financial sector since the GFC (Basel III, and MiFID II most notably) have tightened financial conditions and reduced the simulative impact of lower interest rates. (Avoiding the Big Crunch – policies to prevent a deflationary world.) The solvency and liquidity regime of Basel III alone has, by widening lending rate spreads to the central bank policy rate, lowered the neutral policy rate. New Zealand is a key example of this trend given that the RBNZ created the liquidity framework that the BIS adopted as a pillar of Basel III and hence is an early adopter. (Chart 2.) Basel III alone has contributed to a 200bp decline in RBNZs neutral policy rate since 2008. Just as Generals are often said to fight the last battle, so are regulators fighting the last crisis: regulators are focussed on averting another systemic liquidity and solvency crisis, but the greatest economic challenges of the current age are a slow burning growth crisis and an income-lite recovery.
Chart 2. RBNZ created the liquidity framework of Basel III. New Zealand therefore showed the world how wider lending spreads lower the neutral policy rate
- Macro-economic policy reflation remains un-coordinated across reflationary levers and geographies. Inappropriately, tight fiscal policy and restrictive global regulations have left monetary policy as the only tool of stimulus in town. Monetary conditions need to be particularly loose to offset inappropriately tight policies elsewhere. (The Global Growth Crisis – A better coordination of reflationary levers?.)
- The lingering impact of the GFC on US household consumption patterns has seen a structural decline in the propensity to consume, and has also encouraged balance sheet deleveraging. (The income-lite recovery trend – does the UK labour market portend continued weak US wage growth?.)
A lower neutral policy rate and a lower “biting point” for monetary policy
A 25bp hike equivalent to a 75bp hike in old money
One of the obvious implications of a decline in the neutral policy rate is an increase in the sensitivity of growth to each bp change in policy rates, other things equal. A 25bp increase in policy rates from a current target range of 25-50bp is far more significant when the neutral rate is 1.75% than when it is 5.0-5.5% – it comprises a larger degree of policy tightening. Indeed, in light of the slump in the neutral policy rate, a 25bp hike by the Fed at present would be considered, equivalent other things equal, to a ~75bp increase pre-GFC. The narrowing of the range between the zero bound and the neutral rate could argue for a decline in the increment of Fed policy tightening from the pre-crisis norm of 25bp, towards a 12.5bp or lower. A counter argument is that the range of monetary policy has simply shifted lower, and that rather than a 0-5.5% range of expansionary to neutral policy, the new range is, for instance, -3.75% to 1.75%. However, this ignores the adverse externalities associated with negative policy rates, which significantly and increasingly dampens the expansionary aspect of rate cuts below the zero bound.
If the Fed believes the US still had a zero bound problem, more QE would accompany a rate hike
Even if we ignore the adverse consequences of negative rates, a 25bp tightening would not be so restrictive if the Fed believed that it still faced a zero bound problem, whereby the appropriate level for policy rates lay below zero. However, this is not the case in the US – at least not in the Fed’s thinking. After all, if the Fed felt that the appropriate nominal interest rate were below zero or even below it’s current Fed Funds rate, the only way it should consider a hike would be if this was combined by an offsetting expansion of quantitative easing. This reflects how QE has an impact that is substitutable for interest rate cuts (but naturally comes with far fewer negative side-effects that when a central bank imposes an NIRP).
The Fed assumes a steady increase in its neutral policy rate to 2.9%
The Fed’s DOT plot forecasts a rise in the neutral Fed Funds rate to 2.9% over the medium-term or to 90bp in real terms. This assumption underpins their anticipated/ hoped for capacity to generate such a notable policy tightening. It is of course possible that the neutral policy rate moves notable higher, but the current trends in global growth and global trade-turnover, in productivity growth, and in the continued sub-optimal nature of global policy reflation all argue against such an outcome. The market’s far more muted expectation of the path of the policy rate has proven much more accurate than the Fed’s in recent years. (Chart 3.)
Chart 3. The market continues to question the Fed’s hoped for tightening path
The Fed could help push the neutral policy rate lower
In fact, one of our concerns is that the neutral real rate declines further. This could result from factors such as a continued weakness in productivity growth or another economic downturn in the US at a time when echoes of the GFC still reverberate so strongly across the economy. The US political cycle also contains the possibility of a further decline in neutral policy rates. If, for instance, Donald Trump were elected President and enacted some of the more controversial pillars of his domestic and foreign policy platform, there could be the emergence of a risk premium embedded into financial assets and corporate investment decisions, which could require the neutral rate to decline further. Given these risks, a premature Fed hike that could slow economic activity could be a factor that at best limits a recovery in the neutral real rate and at worst depresses it further. That is the irony in the Fed’s current analysis of the long-term consequences of conducting monetary policy in a climate of a lowered neutral real policy rate: by hiking without a compelling reason to do so they may exacerbate their own neutral rate problem.
The US yield curve would be resilient to a Fed tightening
A Fed rate hike would not spur a higher, more bearish trading range
This assumption of the neutral real rate helps provide some confidence on the outlook for medium- and longer-term US interest rates as the Fed tries to find reasons to execute its hawkish bias against the backdrop of persistent talk of a UST bubble. Indeed, from 10-years out, US yields offer value for long/ received positions, and as we discuss below we would not expect a Fed rate hike to be enough to push yields into a new, higher and more bearish trading range.
10-yr USTs should trade at a discount to the neutral Fed Funds
The 10-year point of the curve tends to be particularly drawn to the level of neutral policy rates, which reflects how a decade would – at least pre-GFC – be expected to encompass the gyrations of a business and monetary policy cycle. Because of this and also in the interests of simpliciy, we will focus our analysis on the 10yr part of the US curve. 10yr USTs currently yield 1.60%, close to but below the neutral rate of 1.75%. We view it appropriate that 10yr USTs yields are trending below the Fed’s neutral policy rate. This reflects a number of factors:
- Most obviously, the market is sceptical regarding the degree of monetary tightening envisioned by the Fed. (Chart 3.) With the market anticipating a far more modest level of policy tightening, prolonged low yields would naturally limit the extent to which the 10-yr part of the curve would embody a rise towards neutral policy rates.
- The post-GFC regulatory wave has increased the importance of risk free assets as collateral instruments as banks are required to hold a growing pool of government bonds on their balance sheet as capital. (Chart 4.)
Chart 4. US bank holdings of USTs relative to balance sheet have doubled since the GFC
- The compression of government bond yields across the OECD is supporting the relative appeal of USTs. In the current climate, USTs offer relatively high yields, no requirement for a credit risk premium and high levels of liquidity relative to many other key government bond markets.
During the summer sell-off, the rise in the 10yr UST stopped at the neutral rate
If anything, we view the gap between 10-yr USTs and the neutral policy rate as too narrow. The factors outlined above make us comfortable with a 10yr UST yield of 1.50% or below. USTs are a buy on sell-offs that approach the 1.75% neutral policy rate, and as noted above a premature Fed rate hike would increase our medium-term bullishness towards USTs. Importantly, during the summer sell-off, the 10yr UST yield did not move above 1.75%.
USD swaps – a persistent inverted ASW to go the way of persistently wide cross currency basis swaps?
A greater anomaly lies in the USD IRS swap curve whereby UST ASWs are deeply inverted as swap yields have moved below USTs. (Chart 5.) The 10yr USD IRS currently yields 1.45% or 15bp below the equivalent UST. While the negative ASW spread may tempt some investors to establish a 10yr ASW spread widener, a number of technical factors have underpinned this inversion of the spread. Some of the factors include the relatively brisk pace of corporate debt issuance in recent years which has encouraged receiving interest of IRS as issuers turn fixed rate debt into floating liabilities, diminished liquidity/ increased transaction costs of repo financing of USTs, and a withdrawal of risk capital from the market which limits the capacity of institutions to “normalise” curves. As with persistently wide cross currency basis swaps, inverted US bond-swap spreads may be a persistent feature of the market. However, the ticker-shock of an inverted UST ASW may see come investors feel more confortable in buying USTs rather than receiving matched maturity USD IRS.
Chart 5. 10yr UST ASW spreads have inverted
USD IRS forward curve offers particular value
When positioning for a declining neutral policy rate, interest rate forward curves tend to provide particularly attractive tools to express a view. This is because forward interest rates have both a level and a slope component, both of which tend to be benefit from lower neutral rates as curves flatten at lower yield levels. (Yield curves flatten/ invert at lower short-term interest rate levels and the neutral rate declines) This is one of the key reasons why we have focussed so much of our analysis on the USD IRS 5fwd 5yr interest rates, which we believe should be trading around the neutral policy rate and which should experience a tighter spread to the UST 10yr as the forward curve flattens. One of our favoured trades heading into last December’s 25bp Fed hike was receiving the USD IRS 5fwd 5yr at 2.75%. At the time we were assuming a neutral policy rate of around 2.0%, which implied that the yield could drop 75bp just to get to more appropriate pricing levels. In June we changed our forecast of the neutral rate/ pivot point for the USD IRS 5fwd 5yr to 1.75%, which we assume equated to a broad 1.50 to 2.0% trading range. (Chart 6.) (The UK decided Brexit – an uncharted path to Tartarus?.)
Receive the USD IRS 5fwd 5yr
At 1.74% the USD IRS 5fwd 5yr is in the middle of this trading range and we would look for any sell-offs to establish fresh received positions. For choice, we would receive this interest rate at current levels looking for a move towards the lower end of the assumed trading range, which reflects the on-going political uncertainty as the US Presidential election heads to its denouement, our concerns of emerging signs of a softer economy, as US inflation concerns are expected to continue to fade and as the risks surrounding the global economy mount. By increasing the potential for a further decline in the neutral fed Funds arte, a continued hawkish Fed could comprise another reason to receive the USD IRS 5fwd 5yr.
Chart 6. A trend of lower US 10yr yields in spot and forward space is expected to resume
In conclusion – lower neutral rates are one of the structurally bullish factors for USTs
USTs can have a sustained sell-off, but this may require fresh information
We have been structurally and – for the post part tactically – bullish core government bond markets since (and before!) the GFC. Some of the factors underpinning our view have been our expectations of a continued weak global recovery, of downside risk to global inflation and of a growing tendency of government bonds to be viewed by investors more as collateral instruments rather than yield products, The decline in central bank neutral policy rates has been an additional factor underpinning our bullishness, since it has supported lower yields and a compression of the forward curve. An awareness of neutral policy rates can help ease concerns that some bond markets have emerged into acute bubble territory, and this is particularly the case in the US where the curve appears appropriately priced if not with yields too high following the summer sell-off. Of course lower neutral rates to not preclude a sustained sell-off and trend reversal in USTs. However, for a sell-off to be maintained it would require fresh information such as an unexpected upsurge in the US growth and inflation outlook. Absent fresh information, the lower neutral policy rate provides resilience to the UST curve and can help limit sell-offs.
The Fed’s dilemma
Meanwhile, the Fed is devoting considerable time and analysis to determining how a lower neutral policy rate influences the conduct of monetary policy. It has considered introducing more stretch inflation targets (which appears a bad idea when the current inflation target is proving so illusive). It has also recognised that a lower neutral policy rate is likely to increase the amount of time it encounters a zero bound problem, which argues for a long-term role for QE as a policy tool. This debate should also caution the fed against hiking until the need to raise rates is compelling. To hike prematurely could exacerbate the Fed’s dilemma by maintaining the downtrend in the neutral policy rate.